Keynote Interview: Pacific Equity Partners on Australia

With international attention typically focused on Australia’s vast commodity base, from iron ore extraction to cattle farming, the diversity of its economy – and that of its neighbour New Zealand – is often overlooked.

As Pacific Equity Partners invests its fifth fund, an A$2.1 billion ($1.6 billion; €1.4 billion) vehicle that closed on its hard-cap in September 2015, Sydney-based managing director Jake Haines describes the breadth of investment opportunities in those markets, supported by robust domestic demand.

What are the main macro-economic drivers shaping the investment landscape?Many people see Australia as a resource-centric, heavy industry-based economy and that’s just not the case. Australia has a domestically-focused economy, and within that, about 70 percent is driven by services. Population growth is a central pillar averaging 1.5 to 2 percent a year compared to the US and UK, which are closer to 0.5 to 0.7 percent.

Migration is a significant contributor, bringing skills, producers and consumers into the country. Australia’s balance sheet is also relatively strong. Net debt as a percentage of GDP is low which creates a solid foundation for the economy to weather any uncertainty, volatility and negative impacts.

Has the global mood of uncertainty spread to Australasia? It has definitely had an impact on sentiment and confidence, although, for individuals, I think job security is the fundamental driver of confidence. The conditions in Australia are very supportive of a stable level of employment. Consumption figures are solid, and a reflection of reasonable consumer confidence.

Australia has experienced a lot of leadership change recently. What impact has that had?Beyond the media headlines, there hasn’t been a huge amount of disruption at the macro level. The change in governments has created some challenges around transparency of policies within certain industries such as healthcare and energy, but the fundamentals of the economy remain sound. Both Australia and New Zealand are forecasting continued GDP growth over the long term of about 3 percent – which is consistent with the last 25-plus years.

China is Australia’s largest trading partner. Does slowing growth pose a risk, or is China still an opportunity? In terms of exports, China represents about 6 percent of Australian GDP. Australia supplies China with iron ore and is the largest, lowest cost producer in the world. It is closer to China than some other producers and will always be a primary base-load provider. Over the long term we expect demand to be stable.

In addition, Australia supplies a broad range of products and services to China ranging from medical IT to frozen bakery goods. There is significant opportunity for investors like us to buy very high quality platforms [in Australia and New Zealand] and export products and expertise to Asia – China particularly – where there is increasing demand.

That creates an attractive value proposition on exit for offshore pools of strategic capital looking to invest and further expand the business and capabilities within their home markets. We’ve seen this dynamic play out across a number of our investments.

Lots has been made about the tightening restrictions on outbound capital from China but the [Chinese] government has expressed continuing support for investment in strategically important areas. Healthcare, education, and food and beverage have all remained at the top of that list and we expect to see continued interest.

How have economic conditions impacted dealflow?One interesting aspect of this more volatile time is the willingness of vendors to engage with private capital. The ability to strike a deal often relies on the vendor forming the view that the price they can obtain today might not be the price they get tomorrow. A bit of volatility is probably not a bad thing from our perspective.

We look for industries where we can add value and double profits. We put a big premium on revenue growth and ensuring we can get that engine firing. We steer clear of opportunities with exogenous risk, including political, foreign exchange and commodity-based risk factors that are outside of our control. That formula tends to be relatively well insulated from short-term volatility.

Which sectors are attractive? We cast a pretty wide net and are active across a broad range of industries from consumer sectors – we’ve done a lot in food and beverage – to industrials to financial services and healthcare. In most cases we are looking for the leader in a market that is stable and growing, where we understand the fundamentals and the competitive landscape and there is a set of very clearly identifiable operating levers that we can pull to dramatically impact profit. We believe our core skill is identifying opportunities, defining where to make changes and where to apply resources. We have a broad network of managers who we’ve worked with across our many years in the market and look to get them plugged in early and develop our thesis from the outset. That tends to define our deals, rather than any particular industry or vertical expertise.

What size deals is Fund V targeting? Our sweet spot is probably in the A$200 million to A$800 million range – with capacity up to $1.5 billion – but investment is driven much more by the opportunity. As an example, we recently invested in New Zealand health products business, Manuka Health, which was at the lower end but the opportunity to deploy a material amount of additional capital and take advantage of a steep growth trajectory made it interesting to us.

Half of our deals have been carve-outs. The first investment we made out of Fund V in May 2015 was in a business called Pinnacle Bakery & Integrated Ingredients that was owned by Kerry Group, a listed ingredients business based in Ireland. Pinnacle was their only business globally that manufactured and distributed sweet bakery products and was non-core to Kerry.

We had spent time with the Kerry team over the years and came to know the business. When they began to think about liquidity we convinced them to let us take a couple of weeks to look through the data. We returned with a very clear diligence plan and deal structure we could deliver quickly. We signed the deal in six weeks.

At the other end of the cycle, are initial public offerings still a popular exit route? It’s a generally supportive IPO market but not what we saw a couple of years ago. The negative press about private equity exits in the public markets [following the collapse at the end of 2015 of listed electronics retailer Dick Smith] has washed through. Most managers were pretty disappointed with how private equity was cast in the shadow of that specific experience, particularly given that data shows PE-backed IPOs have outperformed other IPOs.

Our exits have been split 40/60 between the public markets and trade sales, which have included exits to some large offshore conglomerates. We place a premium on investments where the potential bidder universe on exit is diversified. In recent years, many managers have been running parallel processes for trade and IPO exits which is likely to continue.

In October 2015, Pacific Equity Partners partially exited its stake in fund administration and share registry business Link Group selling A$947 million of shares on the Australian Stock Exchange, the largest initial public offering of the year.

As of September 2016, the exit had generated a 9.7x return and internal rate of return of 122 percent for PEP Fund II, which first invested in Link in 2005. Over the course of PEP’s ownership, revenue grew by 350 percent and EBITDA by 384 percent. Employee numbers shot up from 350 to 4,300. PEP’s Jake Haines explains how all this was achieved.

Why Link?We identified two corporate orphans in the administration space and put them together to create Link Group. Both were carve-outs, one from a joint venture in Australia and the other from a large corporate. One kept records associated with share ownership, that was Link, and the other for pension administration, which in Australia is significant given mandated superannuation contributions.

When we acquired Link in 2005 it was number two in the share registry market and growing aggressively. Our thesis was the business could leverage trusted relationships and its record-keeping and administration capabilities to build out the product suite and cross-sell into its customer base.

Over the 11 years of our investment, the business grew the average number of products sold by more than three times. New value-added services created much stickier customer relationships. It was a very stable, highly resilient business, which gave us an opportunity to invest significantly in back office systems to drive operating efficiencies.

On the pension administration side, we acquired that business in 2006, slightly ahead of the industry’s shift from in-house administration to outsourcing. We invested a significant amount of capital from 2006 to 2007 into building its technology platform. As funds decided to outsource, the company gained a disproportionate share of the market.

As a group, the business expanded geographically into South Africa, Asia, and Europe, both organically and through bolt-on acquisitions.

Eleven years is a long hold. Why didn’t Fund II exit sooner? The short answer is the level of returns on our holding value and the level of growth in the business was so significant that it made sense to continue to own it. There were so many opportunities to invest back into the platform and earn very attractive returns on that additional investment.

In 2015, the business made a transformational acquisition and we saw a very transparent path to future growth. It made sense for us to think about liquidity at that point. If you want to get a premium value for your asset from the next buyer, you can’t have squeezed the lemon dry.

As we surveyed the exit landscape it was clear there was lots of demand for that type of story from the public markets. The company was the right size for an attractive level of institutional support so we decided to IPO. We didn’t sell down completely, we held a third post-IPO and then we sold out over the course of the next year in two successive block trades.

What were your key achievements? We managed to get the right team in place early, which happened to be the team embedded in the first acquisition. We had a very clear strategy about where we wanted to focus both management time and capital and we made sure that we followed through with that.

And challenges?There were a few rocky periods early on when we’d committed a significant amount of capex to the technology rebuild in the firm belief that clients would come. All of our research and diligence suggested they would, but you can never be entirely sure. In any major project there are always those uncertain times.

But it was critical that we did commit that capital. It created a very differentiated platform that helped to take the business to the next level, gain market share, build out the product suite and achieve efficiencies as we grew.

This interview is sponsored by Pacific Equity Partners and was published in the PEI Australia Special 2017 in June 2017.